Discount Instrument

Explained:

In the fixed income markets, there are a variety of instruments that, rather than paying interest as coupons, pay it at maturity. They are issued at some price and later mature for a greater value. This article focuses on short-term, money market forms of these instruments. See the article zero-coupon bonds for the longer-term forms.

The instruments fall into two categories.

The first category might be called accrual instruments. These instruments are issued at some face value and mature for a value equal to that face value plus interest.

The second category is discount instruments. These have a face value that represents their maturity value. They are issued at a discount from that face value.

This distinction is illustrated in Exhibit 1.

Cash Flows of Accrual and Discount Instruments
Exhibit 1

Cash flows of an accrual instrument are compared with those of a discount instrument. The accrual instrument is issued for its face value and matures for its face value plus interest. The discount instrument is issued at a discount from its face value and matures for its face value. In both graphs, the face value is assumed to be USD 100.

Accrual instruments are quoted as yields. Discount instruments can be quoted on a price or yield basis. Yields are calculated differently for the two types of instruments, so a yield quoted for one is not comparable to a yield quoted for the other.

Yields for accrual instruments are quoted as simple interest rates. Yields for discount instruments are quoted as discount yields. If comparisons with other instruments' yields need to be made, a discount instrument's yield may be converted to bond-equivalent yields.

In the money market, examples of accrual instruments include

Eurodollar deposits,

certificates of deposit

fed funds, and

repos

Discount instruments include

T-bills,

commercial paper, and

bankers acceptances.